Reliance Industries rating ‘hold’; Deal for Future Group highly synergistic

Customers browse groceries at a Big Bazaar hypermarket, operated by Future Retail Ltd., in Mumbai, India, on Sunday, April 16, 2017. (Image: Bloomberg)

The acquisition of the Future Group (FG) by Reliance Retail (RR), wholly owned subsidiary of Reliance Industries (RIL), is highly synergistic; however, it shall require significant restructuring. Key highlights: (i) We believe FG’s retail business makes a strategic fit into RR: FG has a large mix of grocery sales vis-a-vis RR and considering that RR itself shall have keener focus on groceries going forward following the launch of JioMart, FG’s acquisition shall accelerate growth; (ii) RR’s Ebitda/store is 4x FG’s; hence RR may gain from operating leverage, assuming it can turn around FG; (iii) given RIL’s mammoth size with retailing at ~10% of FY21e Ebitda, we reckon FG would add less than 2% to RIL’s consolidated Ebitda. Reiterate Hold on RIL with a TP of Rs 2,105.

FG addition to raise RR’s turnover by one-fifth: The deal would add ~18% to RR’s turnover, but a lower ~15% (taking Future Retail and Future Lifestyle stores) to store count as Future Retail store formats are larger. However, Ebitda/sq foot would be dilutive as RR has been much more efficient at Rs 2,691/sq foot against Future Retail’s Rs 646/sq foot in FY19.

Inorganic growth at modest cost, but near-term RoCE dilutive: The FY19 Ebitda of Future Retail and Future Lifestyle was Rs 15.6 bn, for which RR shall pay Rs 247 bn, i.e. an EV/Ebitda of ~16x. The former two companies make up nearly nine–tenths of the sales turnover of the acquired businesses. Notably, RR shall pay an additional Rs 28 bn for the acquisition of shares (6.09%) and warrants (7.05%) of Future Enterprises.

Prima facie, this would dilute RR’s RoCE for two reasons. First, RR earned a much greater RoCE of 30.2% during FY19, and we forecast that this shall rise to 38.1% during FY22e versus Future Retail’s 17.8% during FY19. Second, while RR should be able to increase FG’s profitability by bringing in its own efficiencies, this may take a few years while RR’s capital employed shall more than double (from Rs 240 bn) in the wake of this deal.

Outlook: Wary of new-FAANGled exuberance— We believe RIL’s FAANG-like valuation (particularly Jio’s) is misplaced as O2C and telecom make up 70% of value. Our two-stage reverse-DCF analysis shows the market is baking in high EPS growth, particularly for Jio (35% CAGR sustaining for 10 years).